The purpose of the previous example is to illustrate that the key difference between stock trading and futures trading is not the volatility of the underlying tradeables. The key difference between trading stocks and trading futures is the amount of capital required to enter a trade and the resultant percentage return on investment. This can best be illustrated with an example. First let’s consider stock trading. In order to buy $100,000 worth of IBM stock Investor A must put up $100,000 in cash (you can buy IBM stock on margin. To do so you would put up
ABBOTT LABS 36.7 CATTLE FEEDER 8.7
AMER EXPR 41.1 CATTLE LIVE 14.6
A M G E N 45.3 C O C O A 40.3
A N A L O G - D E V I C E S 59.3 C O F F E E 65.1
APPLIED-MATERIA 58.5 COPPER 28.2
A S A 41.5 C O R N 24.5
A T M E L 68.9 C O T T O N 23.8
BANC ONE CORPOR 37.8 CRUDE OIL 35.4
B A N K A M E R I C A 39.2 DJ FUTURES 13.3
B A R R I C K - G O L D 50.1 DOW FUTURES 23.9
B I O G E N 45.8 G O L D 34.1
B O E I N G 34.9 HEATING OIL 37.2
CABLETRON SYSTE 76.6 HOGS LIVE 36.0
C C U B E 57.6 L U M B E R 35.2
CHASE MANHATTAN 38.0 N Y F E 13.3
CIRRUS LOGIC 78.7 S&P FUTURES 17.5
CISCO SYSTEMS 44.4 S&P MINI 19.8
C M G - I N F O - S E R V I C 68.7 SILVER 30.0
C O M P A Q 52.1 SOY MEAL 29.6
C O M P U W A R E 67.5 SOY OIL 25.8
C O N S E C O 55.4 T - B O N D S 8.9
CREE RESEARCH 67.7 T N O T E 5 4.4
CYPRESS-SEMI 78.0 UNLEADED GAS 33.0
DELL COMP 53.0 W H E A T 26.4
AVERAGE STOCK 5 4 . 0 AVERAGE FUTURES 2 6 . 2
V O L A T I L I T Y V O L A T I L I T Y
STOCK % FUTURE %
$50,000 in cash giving you 2-for-1 leverage. However, for the purposes of our example, we will forego margin buying). If Investor A puts up $100,000 cash to buy
$100,000 of IBM stock and IBM stock rises 3%, Investor A will make 3% on his investment. If IBM stock declines 3% he will lose 3% on his investment. Pretty straightforward. Now let’s consider a futures trade.
Each futures contract has a standardized contract size.
When you buy a Soybean contract you are buying the right to purchase 5,000 bushels of Soybeans. For Soybeans a one cent move ($0.01) is worth $50. Now let’s do some math. Let’s say Soybeans are presently trading at a price of $5.00 a bushel. With a current price of $5.00 a bushel, the contract is currently trading for the equivalent of 500 cents. 500 cents times $50 a cent means that you would be purchasing $25,000 worth of Soybeans. Thus, if Investor B buys four Soybean contracts at $5.00 a bushel he is buying $100,000 worth of Soybeans. Now here comes the key difference between trading stocks and trading futures: to purchase (or to sell short) a futures contract a trader does not need to put up cash equal to the full value of the contract. Instead, he need only put up an amount of money which is referred to as a “margin.”
Minimum margins are set by the futures exchanges and may be raised or lowered based on the current volatility of a given market. In other words, if a particular market becomes extremely volatile, the exchange on which it is traded may raise the minimum margin. As this is written, the amount of margin required to trade one Soybean contract is $750. So in order to buy $100,000 worth of
Soybeans, Investor B in our example must buy four contracts at $5.00 a bushel (500 cents x $50/cent x four contracts). However, unlike Investor A who had to pony up $100,000 cash in order to buy his IBM stock, Investor B need only put up $3,000 of margin ($750 per contract x four contracts) in order to make his trade. And therein lies the quality that makes futures trading a highly speculative endeavor—leverage.
If IBM stock rises 3%, Investor A will make 3% on his investment. If Soybeans rise 3%, from $5.00 to $5.15, Investor B will make a 100% return on his investment (15 cents x $50 per cent x four contracts = $3,000). So what we are talking about in this example is the difference between 1-to-1 leverage versus 33-to-1 leverage. When you boil it all down, it is this leverage which gives futures trading its great upside potential as well as its frightening downside risk. If IBM declines 3%, Investor A will lose 3% on his investment. If Soybeans fall 3% from $5.00 to $4.85, Investor B will lose 100% of his investment (- 15 cents x $50 per cent x four contracts = -$3,000).
Leverage is the double-edged sword that makes a few people very rich and upon which the majority of futures traders fall.
Very few individuals have the stomach to trade with leverage of 33-to-1. More unfortunately many traders do not clearly understand that they are using this kind of leverage when they trade futures. Those in the greatest danger are the ones who read about “how to make a fortune in Soybeans for just $750!,” or “how you can control $25,000 worth of Soybeans for just $750.” Also,
some traders are unaware that futures trading involves unlimited risk. If you enter the aforementioned Soybean trade, buying four contracts at $5.00/bushel, your initial margin requirement is $750 a contract, or $3,000. Based on their prior experience in stocks or mutual funds or even options, some traders mistakenly assume that this is all they can lose. Not so. If Soybeans happened to trade down lock limit ($0.30/day) just two days in a row, this trader would be sitting with a loss of $12,000 ($0.60 x $50/cent x four contracts) and counting. This illustrates the importance of having a “cushion” and not “trading too big”
for your account. The phrase “trading too big” can be defined as the act of trading with more leverage than is prudent given the size of your trading account and your own tolerance for risk.
Why Do Traders Make Mistake #2
Unfortunately, the blunt answer to the question “why do traders use too much leverage” is “ignorance.” This is not to imply that everyone who trades futures is ignorant (although there are those who might debate this). What it means is that many traders are unaware of the amount of leverage involved. Too many traders get into futures trading without realizing or understanding the amount of leverage involved. People who trade stocks for years (putting up $1 of cash to buy $1 of stock) often mistakenly assume that they are doing the same thing with futures.
They simply don’t realize that when they put up $1 they may actually be buying or selling $33 worth of the underlying commodity. Few people are prepared to deal with 33-to-1 leverage. To make matters worse, those who
don’t even realize they are using 33-to-1 leverage have almost no hope of surviving. It is sort of like taking a test drive in an Indy race car. You know it can go fast so you prepare yourself a little, but you are used to driving the family sedan whose top speed might be 80 miles an hour.
So you strap yourself in, put your foot on the gas and suddenly find yourself hurtling down the track at 220 miles per hour. The odds of your avoiding a serious accident are slim. And so it is, too, for the unenlightened futures trader.
Another problem is that there are few warnings given regarding how much leverage is too much. Brokerage houses make money based upon the number of trades made so they don’t have a great incentive to tell somebody
“you’re using too much leverage; you should trade less.”
Another problem is that although there have been many good books written regarding money management, there remains no standard method for determining the proper amount of leverage to use when trading futures.
How To Avoid Mistake #2
The antidote for using too much leverage is referred to as proper “account sizing.” Account sizing simply refers to a process whereby a trader attempts to arrive at the “right”
amount of leverage for him. The goal is to strike a balance. You want to use enough leverage to be able to generate above average returns without using so much leverage that you expose yourself to too much risk. The ultimate goal of sizing an account is to limit any drawdowns in equity to a percentage amount which will not be so large that it causes you to stop trading. In
order to do so you must prepare yourself as much as possible both financially and emotionally for the magnitude of drawdown you are likely to experience using your chosen approach to trading.
There is no one best way to arrive at the “perfect” amount of capital to use to trade a given portfolio. There are, however, several key factors to take into account. The ideal method is to develop a portfolio of markets and trading methods, figure out the proper amount of capital needed to trade each market, and then allocate that much capital into your trading account. From a practical point of view most traders do not have this luxury and must approach the problem from the other end. In other words, most traders don’t say “here is the optimum portfolio and the required amount of capital to trade it so let me just write a check to my broker for this amount.” Most traders say “I have x-number of dollars to commit to futures trading. What can I do with it?” If your optimum portfolio requires $50,000 to trade (according to the methods we will discuss in a moment) but you only have $25,000 with which to trade, you must either alter your optimum portfolio or save up another $25,000.
Assuming you are going to trade a diversified portfolio of markets, the first step is to build a test portfolio and look at the historical trading results for each individual market using the trading approach you have selected. What you want to accomplish is to arrive at a reasonable amount of capital to have in your account in order to trade one contract of each market. If possible, you will also want to consider the performance of the portfolio as a whole,
to determine if more or less capital is required. In order to obtain the most useful results it is best if you have some method available to generate a trade listing for each market that you intend to trade using the approach you have chosen. It is also helpful to be able to analyze monthly profit and loss data for the portfolio as a whole.
If you have actually been trading for a while you may be able to use your past monthly statements to obtain the necessary data.